The U.S. Trade Deficit

The twin oil price shocks of 1973-1974 and 1979-1980 vividly
exposed the interdependence of the United States and the world
economy. Exports as a share of total U.S. production had
increased dramatically since World War II, and more U.S. workers
were exposed to the vagaries of the international marketplace.

The global recession that followed the second oil price shock
caused international trade to stagnate; global trade actually
fell in 1982 and 1983. The United States and many other nations
struggled to overcome inflation and recession, and to achieve
economic recovery and growth.

At the same time shifts in international competitiveness were
beginning to be felt. By the late 1970s, many countries,
particularly newly industrializing countries, had begun to
demonstrate increased ability to compete on a global basis. South
Korea, Hong Kong, Mexico and Brazil are just a few of the
countries that had become efficient international producers of
such products as steel, textiles, footwear, auto parts and many
consumer products. These new conditions altered the global trade
environment and the dominant position of the United States within
that milieu.

As other countries became more successful, U.S. support for
liberal trade began to erode. U.S. workers in export industries
worried that other countries were unfairly winning markets in
third countries through foreign industrial targeting -- the
direct support that foreign governments give to select
industries, such as steel -- and through trade policies that
explicitly promote exports over imports.

During this period, many U.S.-based multinational firms began
moving production facilities overseas. Technological advances
made such moves more practicable, and a change in locale was
often made to allow a firm to take advantage of lower wages,
fewer regulatory hurdles or other conditions that would reduce
production costs. Many goods that the United States had
previously exported began to be produced overseas.

Yet the event that had the most adverse affect on the U.S. trade
balance -- the ratio of imports to exports -- was the unexpected
jump in the foreign exchange value of the dollar. Between 1980
and 1985, the dollar's value rose some 40 percent in relation to
the currencies of major U.S. trading partners. It was as if a tax
had been placed on U.S. exports, while a subsidy had been given
to foreign imports.

In 1972 foreign imports exceeded U.S. exports by $5.7
thousand-million. By 1985 the value of imports over exports had
ballooned to well over $100 thousand-million, and the merchandise
trade deficit hit a high of $152 thousand-million in 1987.
However, as the effects of the depreciated dollar began to be
felt, the trade deficit started downward; by 1990, it had
dwindled to $101 thousand-million. But why did the dollar
appreciate? The answer can be found in U.S. recovery from the
global recession of 1981-1982 and in huge U.S. federal budget
deficits, which acted together to create a need for foreign
capital. U.S. recovery from the recession began in the end of
1982, earlier than it did in other countries. With recovery came
an increase in U.S. demand for goods including imports. U.S.
imports jumped 24 percent from 1983 to 1984. Foreign demand for
U.S. goods did not grow at the same rate since recovery had not
yet begun in other countries.

At the same time U.S. recovery brought an increase in demand for
funds for domestic investment. Yet U.S. savings were not large
enough to meet expanding demand for investment at a time of
record federal budget deficits. The combination of large budget
deficits and a tight monetary policy, which was being maintained
to inhibit inflation, kept U.S. interest rates high relative to
rates in other industrialized countries. High interest rates
induced foreigners to invest in the United States. Thus, foreign
demand for dollars bid up the dollar's value.

In the short term, the strong dollar provided significant
benefits to the U.S. economy. By making imports cheaper, it
inhibited inflation, while making it possible for the United
States to finance both an enormous budget deficit and increases
in private investment. But, by increasing the relative price of
U.S. exports, the strong dollar engendered the huge U.S. trade
deficit.

Dollar appreciation was not the only cause of the U.S. trade
deficit, but most policymakers and economists attribute about 50
percent of the deficit to the dollar's rise. Decisionmakers came
to agree that the trade deficit would only fall significantly if
the federal deficit and, thus, the need for international
borrowing, were reduced.

Congress responded to this situation in 1985 by enacting the
Gramm-Rudman-Hollings deficit reduction legislation, which was
designed to force annual deficit cuts through mandatory spending
reductions. (This law was tempered by a Supreme Court review of
its constitutionality, and its original deadlines had to be
scrapped as a result of a ballooning deficit in the 1990s.)

The executive branch also took action to promote orderly
reduction in the dollar's value. In 1985, the U.S. secretary of
the treasury met with the finance ministers of France, Germany,
Japan, and the United Kingdom to discuss actions each could take
to promote the orderly depreciation of the dollar against the
currencies of major trading partners. With central bank
intervention in foreign exchange markets, the dollar gradually
fell, losing almost half its value between September 1985 and
January 1988. By 1988, the dollar depreciation had contributed to
a falling U.S. trade deficit.